Monday, March 08, 2010

The Politics of Behavioral Law and Economics

Rick Pildes

Yesterday's Wall Street Journal observes that behavioral law and economics seems to be on "the wane" in Washington. As the article notes, this is particularly noteworthy because many of the leading proponents of this approach work for the Obama administration, including Cass Sunstein, who as head of the Office of Information and Regulatory Affairs, oversees all regulatory policy. As the WSJ article points out, Sunstein's book, Nudge: Improving Decisions about Health, Wealth, and Happiness(co-authored with Richard H. Thaler), is probably the most widely accessible account of how behavioral economics should transform public policymaking. Indeed, the book describes behavioral economics as a new "Third Way - one that can break through some of the least tractable debates in contemporary democracies." Works like Nudge asserted that behavioral economics would provide a post-partisan synthesis of Franklin Delano Roosevelt's New Deal liberalism and Ronald Reagan's conservative revolt against the New Deal. Thus, it is all the more remarkable that, even with the leading proponents of this new "Third Way" now in positions of power, the approach has turned out to have so much less traction. Why is that?

Behavioral economics, as many know by now, arose as a rejection of classical, rational-choice economics. The central idea was that consumers were prone to various distortions in processing and acting on information, which meant that markets didn't necessarily operate as predicted. The solution was to be more realistic about how people actually make choices, and to use government to improve their decisionmaking processes. Consistent with the New Deal, Nudge strongly defended the need for government intervention in market ordering and proclaims "senseless" general opposition to government intervention per se. Consistent with the Reagan vision, behavioral economists also defend the importance of freedom of choice, with the strong preference such choice entails for market ordering. The synthesis they offered was to defend justifiable government intervention, but to require that intervention to be structured in ways that promote freedom of choice. Thus, the key policy recommendations of behavioral economics turned out to be more and better disclosure of accurate information, so that consumers could make adequately informed choices; sometimes, this approach also suggested using policy to change the "default rules" against which consumers act, so that if higher savings rates were desirable, policy could be designed to require a certain amount per paycheck to be set aside for savings, with consumers being able to opt out of this structure if they didn't want it.

To be sure, there are many areas where policy could be improved and individuals made better off through wise use of behavioral insights. But, I have long been skeptical that "information disclosure" and the related tools of behavioral economics can be a general approach to the various contexts in which good justifications exist for government action. Indeed, this emphasis on informed choice and full information seems to me useful, where appropriate, but it cannot possibly provide a meaningful response to many serious policy problems.

In an essay called Means and Ends In Law and Politics, I reviewed Nudge and explained the reasons for thinking that behavioral economics is much too limited as a tool of policy to provide the kind of synthesis between the New Deal and Reaganism that Sunstein suggested. Here's a brief excerpt, for those interested:

"Take the subprime lending crisis, for example. This is one of many contexts in which Sunstein argues that a Third Way in policymaking would avoid government mandates and would instead focus on ensuring that consumers receive full information in more effective ways. Thus, Sunstein rightly notes that the Truth in Lending Act originally made comparison shopping among mortgages easier because that Act required all lenders to report interest rates in the same, standardized way (through the annual percentage rate, or APR). That regulatory structure was well suited, Sunstein argues, to the conventional mortgages (30 year, fixed rate) of the era in which the Act was enacted.

But today's mortgage market has become far more complex, with creative lenders designing a variety of differently structured loans, including variable rate and subprime loans. Sunstein argues this creativity is all to the good, since it gives consumers more options. But the solution to the crisis that has resulted from the massive numbers of defaults and foreclosures, as well as failures of financial institutions that have followed in the wake of these new lending practices is, in Sunstein's view, for government to require better disclosure of the terms of the loans that have precipitated the current turmoil. As he puts it, instead of more aggressive, direct regulation of credit markets, he "prefers an improvement in choice architecture that will help people make better choices" and thus avoid assuming bad loans. Government action is needed, but it should take the form of mandating more effective disclosure of what are the effective financial consequences of these more complexly structured loans.

But better information disclosure hardly seems an adequate, or even an effective, response to the most dramatic financial crisis the U.S. has faced since the Great Depression. One way to make the point is that information disclosure focuses only on the demand side for these forms of credit. It does not explain the supply side: what aspects of the regulatory and incentive structure led financial institutions and financial markets more generally to supply these new forms of credit when the consequence of doing so has been the self-destruction of many of these institutions and massive damage to the American economy as a whole?

In the wake of the Depression, Congress created many of the institutions and regulatory regimes that have since given stability and credibility to U.S. financial markets. Some of this regulatory structure focused on better disclosure of information, but much of it involved the kind of command-and-control regulation and mandatory requirements that Sunstein's Third Way aims to avoid."

Thus, no surprise that actual policymaking is turning to more traditional tools, despite the presence of many committed behavioral economists in the current administration.

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